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Tax Laws

What You Should Know About the IRA Hardship Withdrawal

An IRA hardship withdrawal is something that you should really think about before making that final decision. After all, taking funds from your IRA, or Individual Retirement Account can lead to having to pay penalties, not to mention possibly needing to declare the money as taxable income at the end of the year. Although there are reasons for making a hardship withdrawal that don’t incur penalties, you still need to be careful. Here’s what you should know about IRA hardship withdrawals and how you could end up getting penalized.

Why Do You Need to Make an IRA Hardship Withdrawal?

IRAs are set up so that you can make a withdrawal if you’re facing financial hardship, such as if you lose a job and need money to live off of. However, in many cases, you’ll need to pay a 10% early distribution fee if you’re under the age of 59 and half, unless you qualify for a penalty-free withdrawal. In either case, you’ll need to report that money as income on your tax return, paying any required taxes on it as well. Plus, you can only withdrawal the amount of money that you need. You cannot just take whatever you wish out of the account, as there are regulations in place preventing this from happening.

Early Distribution Penalties

In general, if you’re under a certain age and need to withdraw money from your IRA, you will be subjected to a 10% early distribution penalty. This penalty kicks in if you’re under the age of 59 and a half. If you’re that age or older, you can withdraw money from your IRA without having to face any penalties at all. In addition, there are a number of certain circumstances in which you can take money from your IRA without having to pay this early distribution penalty.

Making a Penalty-Free Withdrawal

A number of specific situations exempt you from the early distribution penalty. These include:

  • Medical Expenses and Health Insurance Premiums – If you have medical bills that were not covered by insurance or you had no insurance at the time and need funds to pay those debts, then you can withdraw money from your IRA penalty free. However, there’s a catch. You need to pay your medical bills the same year as you make the withdrawal, and you can only withdraw up to 7.5% of your adjusted gross income from your IRA. This means that you may not be able to remove the entire amount that you owe. Also, if you are unemployed and have been receiving unemployment payments for 12 consecutive weeks, and need to withdraw from your IRA to pay your health insurance premiums, you may do so penalty free. With that said, there are a few additional criteria that you need to meet.
  • Paying for College – You may withdraw from your IRA without having to pay an early distribution penalty if you need to pay college expenses for yourself, your spouse, or your dependent child or children. However, those funds can only go for college tuition, room and board, and books and fees, and you are limited in how much you can withdraw.
  • You Are Disabled – If you end up going on permanent disability and can no longer work due to a proven medical condition of any kind, then you can make as many penalty-free withdrawals from your IRA as necessary. You may have to produce proof of your disability, but there are few other restrictions on this reason for withdrawal.
  • You’re a First-Time Homebuyer – Buying your first home, building one, or even rebuilding one are all reasons why you can make a penalty-free withdrawal from your IRA. You are limited to only taking $10,000 out of your IRA for this purpose, and must be a proven first-time homebuyer, which means that you haven’t owned a home for at least two years. (You can have owned a home in the past and still qualify, as long as it hasn’t been any time in the last two years.) Also, your spouse, if they have an IRA, can also withdraw $10,000 penalty-free for this purpose, as long as they are also a first-time homebuyer.
  • You’re an Active Duty Member of the Military – If you are a member of the National Reserve or standard military (Army, Navy, Marines, or Air Force) and are called to active duty for over 180 days, you can withdraw money from your IRA without having to pay any penalties. In addition, you may have up to two years after you make the withdrawal to pay that money back to your IRA. You might be able to make these contributions even after you’ve met your annual contribution limits, although the circumstances may vary.

These are just a few examples of the many reasons why you may need to make an IRA hardship withdrawal. There’s also a new exemption that some people may qualify for.

COVID-19 and Non-Penalized Withdrawals

Thanks to the CARES Act that passed in December 2020, COVID-19 related IRA withdrawals are not subject to the 10% early distribution penalty. However, in order to qualify for this penalty-free withdrawal, you must meet a number of criteria, including:

  • You are withdrawing $100,000 or less from your IRA.
  • You have been diagnosed with COVID-19 using testing methods approved by the CDC.
  • Your legal spouse or one of your dependent children have been diagnosed with COVID-19 using testing methods approved by the CDC.
  • You are having financial difficulties due to being laid off, furloughed, or unable to work due to your COVID-19 diagnosis.
  • You have to work reduced hours due to having to take care of your children due to COVID-19.
  • Your business is either closed or you are struggling financially due to COVID-19.

Although you won’t be subject to the early distribution penalty if you meet any of these criteria, you will still have to report the distribution as income. You have two different options here. One, you can report the entire amount as income on the tax return for the year that you withdraw the money. Or two, you can break the amount into thirds, reporting one-third of it for the year that you made the withdrawal, followed by the remaining two-thirds over the next two years.

You May Still Have to Pay Income Taxes on the Amount

If you’re under the age of 59 and a half, even if you make a penalty-free withdrawal from your IRA, you may still be subjected to income taxes on that amount that you removed. If so, it will need to be listed an income on your tax return for the year in which you made the withdrawal.

If you have had to make an IRA hardship withdrawal and are wondering about having to pay tax penalties or need to make a withdrawal but have not done so yet, then reach out to the tax advisors at Enterprise Consultants Group. We can answer your questions, discuss your rights, and provide actionable options. Please contact us online or at (800) 575-9284 today to schedule a free and confidential consultation to see how we can help you.

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